May 11, 2015

Since their inception, Bitcoin exchanges have operated under a fog of legal uncertainty. Last week, just one day after the New York-based exchange itBit announced obtaining a banking law charter giving it the ability to operate in all 50 states, a California official called that into question.

Almost every state has its own licensing requirements for traditional money transmitters that include payment processors and money transfer firms like Western Union. The safe but costly route for Bitcoin exchanges would be to obtain a license in each state that requires it for digital currency firms. But it's unclear which do.

Texas, for example, stated that transmitting digital currencies like bitcoin doesn't require a license in its state. Other states, like New York and California, are still in the midst of passing digital currency-specific licensing requirements, making it a question of what Bitcoin exchanges should do until those licensing laws are finalized. The prominent and reputable Bitcoin exchange Coinbase, for example, was operating in New York and California without a license in either state—and probably didn't need one.

itBit was able to bypass much of the uncertainty about being required to obtain state money transmitter licenses. It accomplished this by obtaining a trust charter under New York banking law, which is generally required of exchanges in the state.

Under New York law, a trust company is a type of banking organization that is technically distinct from a bank. A trust company has all of the powers of a bank to take deposits and make loans, and also certain fiduciary powers such as acting as an agent for governmental bodies. Firms organized as trust companines in New York include the derivatives clearinghouse Ice Trust, the wealth and asset manager Northern Trust, and the FDIC-insured bank Stuben Trust.

itBit, in particular, is authorized as a limited purpose trust company. This means it is not allowed to make loans or take deposits. To obtain the charter, itBit had to meet the very strict requirements of ordinary New York chartered commercial banks and subject itself to ongoing oversight. However, itBit is not required to obtain insurance from the Federal Deposit Insurance Corporation (FDIC), and it is subject to a much lower level of minimum capital--$2 million versus at least $50 million for a commercial bank.

Despite being organized under New York's banking law, itBit is not a bank in the ordinary sense and it not regulated by any federal banking authority such as the Federal Reserve or the FDIC. Being regulated as a bank would be too expensive and require a level of regulation and oversight ill-suited for a digital currency exchange.

itBit does, however, indirectly provide FDIC insurance to its clients' dollars by holding them at a separate FDIC-insured bank. itBit might be subject to some degree of FDIC oversight or compliance obligations indirectly, but that depends on how closely itBit and its banking partner work together. Bitcoin firms Coinbase and Circle similarly provide FDIC insurance to their customers' dollar accounts.

With a trust charter under New York banking law, itBit is basically in the clear when it comes to needing a state license to operate as a money transmitter.

Under New York's traditional money transmitter statute and its pending Bitlicense, a company chartered under its banking law does not need a license. Nationally, states generally don't require a firm chartered under another state's banking laws to get a money transmitter license.

For example, moving across the Hudson River, New Jersey excludes any federal or state chartered bank from being required to get a money transmitter license in its state, and defines a bank to include a trust company like itBit. Moving westward, things get easier: Illinois is explicit about excluding trust companies chartered in any state from needing a money transmitter license.

But it's when we get out to California that things get a little gnarly.

California does not require a money transmitter license for trust companies authorized under California law. But unlike New Jersey or Illinois, that statutory exemption does not explicitly apply to out-of-state trusts. It's therefore not a surprise that a California official would question whether itBit's New York trust charter is enough for it to do business with California clients.

Nonetheless, itBit seems to be on solid ground to operate in the Golden State. California recognizes that out-of-state trusts may conduct business within its borders. It also recognizes that out-of-state banks, which include trusts, don't need an office to operate in the state. As an electronic exchange, it's unlikely that itBit will be opening an office in California, or any other state, in the near future. Likewise, the laws that permit commercial banks to open branches in other states through interstate reciprocity don't fit the operational model of itBit.

An out-of-state trust authorized to do business in California thus likely qualifies for the money transmitter exemption that applies to trust companies generally. Indeed, there seems to be no precedent or policy reasons for requiring a regulated banking trust like itBit to obtain a money transmitter license. But it would be good to have greater certainty about the issue. Washington State seems to have a similar snag. And Louisiana, at least by statute, requires an out-of-state bank to be a "federally insured depository" institution to qualify for a licensing exemption. It's not clear whether itBit fits that description.

itBit's road to obtaining a trust charter under New York banking law was long and costly. It also proved to be savvy. In one fell swoop, it gave the firm a basis to operate nationally while building confidence in the Bitcoin ecosystem. So it's no surprise that upon announcing its trust charter that itBit also disclosed a $25 million round of financing. By doing so, itBit demonstrated the fundraising benefits of being a regulated firm and that financial institutions are not always on the hunt for minimal regulation.

There seems to be some uncertainty about whether itBit—a banking law trust—automatically qualifies to do business without a money transmitter license in certain states. But that uncertainty should, more than anything else, lead law makers to rethink the patchwork quilt of U.S. state money transmitter laws. As of now, it potentially undermines the operations of global digital currency exchanges.

February 21, 2015

It is difficult to overstate the growing importance of software to companies, whether it be in the form of automated trading, web-based applications and data storage, or monitoring systems to comply with regulation. But software may soon also be changing the very nature of business enterprises by giving rise to digital companies that operate autonomously.

Digital firms taking the form of distributed autonomous companies (DACs) would likely be built using the type of blockchain technology underlying Bitcoin. The benefit of using a distributed blockchain ledger is that a DAC’s identity and activities can be publicly verified and carried out without a central authority or point of failure. The scope for abuse or incompetence could also be reduced because its operational rules would be secure and require consensus to be altered.

A DAC could own assets but would not need employees. Like modern day investment trusts, a DAC could enter into contracts with managers and others as needed to generate profits. A DAC’s automated decision making could also be programmed to operate by distributed consensus, meaning that some of its activities would require the verification or feedback of a network before being undertaken. For example, a DAC that manufactures goods may contract with a supplier but only after the blockchain network verified that the supplier meets certain production quality standards. With advances in artificial intelligence, a DAC might be able to operate mostly autonomously, but would probably still require human involvement at the edges.

But innovation does not do well amidst legal uncertainty. So in order for DACs to become operational and reach their full potential, the law must give them a stamp of approval. I argue that a framework similar to the law of limited liability companies would be the best fit.

The Need for Organizational Law

Organizational law is a set of background rules that governs companies' internal structure. In the United States, it is found in state statutes governing corporations and other types of companies. Organizational law serves several important functions, including:

providing external recognition that a company is an independent legal entity owned by shareholders (personhood);

making enforceable a company’s ability to own assets, enter into contracts, and generate profits and losses;

For these reasons, corporate statutes have long been described as enabling companies to form and operate according to the design of their founders. Delaware's corporate code is the preeminent source of organizational law for public corporations, largely because its case law is sophisticated and widely understood.

For DACs, organizational law would provide foundational rules to govern companies. To "incorporate," a DAC could a transmit a message to a blockchain recording its existence. Each DAC, in turn, would have a more specific set of rules embedded in its own code. These rules would govern its operations and the rights of its owners, and thereby serve the role traditionally served company operating agreements, certificates of incorporation, and bylaws. Organizational law is particularly suited for software code-based entities like DACs that would need to rely on a foundational set of parameters and specifications to permit its more specific operations to take place. The code-based system of organizational bylaws developed by Eris is an example of an operational framework for digital organizations.

As with traditional companies, a state legislature must enact a statute recognizing DACs to make certain that the company’s existence will be recognized and its rights will be enforceable in court. State legislatures recognizing new types of business entities is not uncommon. For example, as of February 2015, 27 states had enacted legislation recognizing benefit corporations, which are a new type of socially-minded for-profit company.

Instead of states adopting DAC statutes, or until they do, it may be sufficient to enact legislation simply recognizing that DACs are a legitimate form of business entitled to rights similar to other companies. For example, the following provisions from a Digital Company Enabling Act could serve as a first step in enabling a DAC to be recognized as a legal person under Delaware law:

SECTION 1. TITLE.

This Act may be cited as the Digital Company Enabling Act.

SECTION 2. PERSONHOOD, RIGHTS, AND POWERS.

A digital company has legal personhood and rights and powers to the full extent provided to limited liability companies under the Delaware Limited Liability Company Act.

SECTION 3. FORMATION.

In order to form a digital company, one or more persons must create, record, or transmit unique and publicly verifiable data that indicates formation of the company.

SECTION 4. DEFINITIONS.

...

“Digital company” means any company that operates primarily on the basis of software code.

While plenty of questions should remain even after the passage of this type of statute, a little bit of law could go a long way.

DACs Should be Structured as Limited Liability Companies, Not Corporations

Like other business entities, the characteristics of a DAC can borrow from the two fundamentally different types of companies: partnerships and corporations. In their purest sense, partnerships are decentralized companies whose owners manage the business and are personally liable for the firm's debts. Partnerships are indistinguishable from their owners, and if a partner goes so does the partnership. At the other extreme are corporations. In a corporation, owners and managers are distinct, and management must be centralized in a board of directors subject to election by shareholders. Corporate shareholders are fundamentally passive and enjoy limited liability.

Although a DAC could take a variety of forms, the law of limited liability companies (LLCs) is best suited for DACs due to its simplicity and flexibility.

LLC statutes first emerged in the late 1970s to allow companies to enjoy the benefits of both partnerships and corporations. LLCs are not taxed on their profits, maintain limited liability for owners, and can adopt decentralized management without a board. But it wasn’t until more recently that LLCs began to take off. By 2007, LLCs were being formed at a faster rate than corporations and being used in a wide range of industries. Large companies have also adopted the LLC form, including Sony Computer Entertainment America, maker of the PlayStation home entertainment console.

A company is often understood to be a "nexus of contracts," and this description fits the LLC better than any other type of business organization. For example, the Delaware LLC Act "give[s] the maximum effect to the principle of freedom of contract and to the enforceability" of LLC agreements. This means that LLC law can accommodate a wide variety of specific business structures and use cases.

Corporate law, by contrast, is more rigid. In a corporation, mergers and changes to the articles of incorporation must be approved by directors and shareholders. In an LLC, these activities can be undertaken by one person or however is specified in the operating agreement.

Corporations also require at least one class of stockholders to have voting rights. Although a corporation can be structured like Google and Facebook with dual class shares that give founders disproportionate voting power, LLCs are not even required to have voting shares.

LLC law also allows managers to eliminate any extra-contractual fiduciary duties owed to shareholders. This allows LLC managers to be free from the nebulous body of law defining when fiduciary duties are violated. But under corporate law, fiduciary duties are sacred and cannot be eliminated.

Profit-Seeking Software: Series LLCs

A simple LLC structure may not be enough to enable DACs to be fully realized, however.

Blockchain organizational law should go further and also enable DACs to operate similar to what are known as series LLCs, which were first recognized under Delaware law in 1996.

The defining characteristic of a series LLC is that it permits a company to form internal companies each having a distinct purpose, owners, managers, and assets. The assets of each internal company can be transferred among each other while still preserving an internal liability shield that protects each company from the creditors of the others.

The general benefit of series LLCs is that they can create distinct businesses without being required to establish a new company from scratch. This likely reduces operational costs and taxes. More importantly, however, is that it enables a company to adopt a wide variety of governance structures and profit-sharing arrangements. For example:

series can be created to seek profits from particular activities and expand, dissolve, or multiply as profits are generated;

assets can be transferred among series based on their profitability or other criteria;

the ability of stakeholders to control, interact with, or share in the profits of different series can change depending on the success of particular series.

Individuals or entities (including other DACs) may interact with a DAC by buying in, contributing work, or being granted shares, as noted by William Mougayar.

The series LLC structure is particularly suited for a digital company created from software. Software code is typically written in a way that relies heavily on establishing hierarchies, defining entities by type, making decisions based on algorithms, and having the results of computations feed back into the system. These fundamental aspects of software architecture fit well into the series LLC legal structure. Series LLCs permit the ongoing creation and rearrangement of assets and distinct companies under the umbrella of a master company.

The following figure is a high-level illustration of the structural similarity between a series LLCs and building blocks of the widely-used approach to software languages known as objected oriented programming.

Under an object oriented approach, the master umbrella LLC can serve the place of the top-level class while each series is a company containing an operational software bundle (an object). Contracts between the master company, among series, or with a manager or other service provider are easily understood in terms of software functions. Numerous other aspects of object oriented programs, from “inheritance” that allows objects to be derived from one another to “encapsulation” that segregates data among objects, also fit easily into the structure and operations of a series LLC.

A series LLC is also conducive to autonomous decision making involving the creation of new companies (a new series) because doing so does not require a new master LLC to be formed. The automatic creation of new companies for certain tasks, or to hold specific assets or data, would likely be a key benefit of DACs.

Entrepreneurs and developers are creating the infrastructure required to make DACs a transformative force. But to make that happen, the law needs to empower them.

November 12, 2014

The year is 1941 and the place is Lake County, Florida, a town just outside of Orlando with a population of about 30,000. The W.J. Howey Company, then operated by Dodge Taylor, is selling plots of a citrus grove along with the right to share in any profits from crop sales. The investment-like nature of Howey's sales eventually landed the company before the United States Supreme Court and resulted in a decision that still has important ramifications for securities law practice.

Fast forward to the present. Cryptocurrency technologies of the sort underlying Bitcoin are beginning to be used to sell software services and access to decentralized ledger platforms. These types of so-called "cryptoequity" have the potential to change how businesses operate, from raising funds to using automated contracts to giving stakeholders a unique voice.

Over the summer, Ethereum reportedly pre-sold over $12 million worth of cryptoequity tokens to fund the operation of its "distributed application software platform." The Ethereum tokens are required for developers to implement software on its platform. Another platform, Swarm, is selling tokens that allow entrepreneurs to use its decentralized crowdfunding technology to raise funds with their own programmable cryptoequities. As of July 2014, Swarm had reportedly sold about $750,000 worth of tokens.

Because of their innovative and somewhat malleable nature, cryptoequities are also operating in a legal gray area.

In 1946, Howey's scheme was blocked when the Supreme Court ruled in SEC v. Howey that the interests being sold qualified as "investment contracts" and hence were subject to regulation by the Securities and Exchange Commission (SEC). The Howey test for qualifying as a regulated investment contract, now canon in the field of securities regulation, requires an agreement to involve an investment of money, a common enterprise, and an expectation of profits from the efforts of a promoter.

If cryptoequity is treated by the law as securities, the organizations that obtained funds by selling them would have to register with the SEC and comply with its disclosure requirements and broader regulatory regime. Yet despite the breadth of the Howey test and being labeled as a type of "equity," the tokens may not qualify as federally regulated investment contracts.

Under Howey, it doesn't matter whether the investment capital comes in the form of legal tender, digital currency, or some other valuable asset. Bitcoin ponzi schemer Trendon Shavers found that out the hard way. However, a contract must subject the buyer to a financial loss for it to be regulated. While cryptoequity in the form of software rights and memberships may fall in value, it would be difficult to characterize them as regulated investment contracts without also including a wide variety of other non-financial, commercial agreements and ordinary product sales. Funds obtained from selling memberships to use an existing facility do notprovide "risk capital" as is the case with securities. To the extent Ethereum and Swarm sold tokens after they were operational, the funds they raised don't qualify as risk capital. However, Ethereum's continued platform development after its token pre-sale makes the sale at least somewhat like a regulated offering.

Cryptoequity may not meet the common enterprise requirement, either. Courts have interpreted a common enterprise to exist when an investor's gain is tied directly to the success of the promoter (or a third party), or at least generally dependent on the promoter's efforts. Applying this "vertical commonality" requirement to cryptoequities, however, indicates they are not securities due to the potentially massive gap between the success of a platform (i.e., the promoter) and an individual token holder.

Individual developers and entrepreneurs may fail using an otherwise successful platform. The converse may be true as well. Tokens may be interoperable so that holders can use them on multiple platforms, or export their underlying applications or projects to other platforms. The fact that Ethereum's platform was recreated on the Bitcoin platform suggests that very little intrinsic relationship exists between the success of a token holder and any particular platform, and certainly not something like a passive investor's relationship to a single company's management. And depending on how they develop their applications, individual token holders may find their purchase to be worthwhile or a waste of money. This potentially different payoff undermines the common enterprise in the "horizontal" sense (i.e., among token holders).

Likewise, what cryptoequity holders actually purchase with their funds may undermine the sale from being classified as a securities offering. The expectation of profits requirement does not exist when a buyer receives a good, service, or property. This is why crowdfunding platforms like Kickstarter are not subject to federal regulation. It is also why courts, including the U.S. Supreme Court, hold that shares in housing cooperatives or condos are not securities, even when they come with a reduction in rent or income from renting common areas. If cryptoequity is viewed as conferring a right to use "real estate" on a ledger, then, like housing shares, they may not qualify as regulated agreements.

The active involvement of cryptoequity holders--either as developers or entrepreneurs--may limit the applicability of federal law as well. Passive parties that rely on managers to generate a profit are the hallmark of securities investors. On the opposite extreme are partners that equally manage a business: the law presumes that partnership interests are not securities. This is because a partner, as opposed to a mere investor, does not rely on the efforts of others and does not need to be protected by the securities laws in doing so. (The same approach applies to LLCs managed by its members.) Buyers of Ethereum's tokens may be viewed as active participants because they promised their purchase was to use and develop on its software platform (and not as an investment). According to Howey, a purchase motivated to actively "develop" property is not a securities investment.

Finally, based on the 1990 Supreme Court case of Reves v. Ernst & Young, cryptoequities may not be regulated because they closely resemble commercial contracts that are obviously not securities. The Reves court held that promissory notes secured by home mortgages or business assets were obviously not securities, and neither were agreements that resembled them. The commercial nature of cryptoequity tokens in providing access to software and fundraising platforms may lead a court to hold the same.

Securities regulation is not meant to guard all types of agreements against fraud and manipulative behavior. So while it remains to be seen how the SEC will approach cryptoequities, there is good reason to believe that at least some types of cryptoequity are too commercial in nature to fall under its regulatory orbit.

November 06, 2014

Products being developed for large, sophisticated players is usually a sign of a maturing market. And the Bitcoin market is no different.

Until recently, derivatives based on Bitcoin, such as those offered by ICBIT and BTC Oracle, were suited only for small, individual traders. But recent months have witnessed the development of two types of derivatives contracts that are suitable for institutional investors and large merchants.

Derivatives are contracts whose value changes based on the value of some underlying security, currency, commodity, or price index. Derivatives can be used to hedge risk, speculate, or take an investment position in the underlying asset or price index.

Derivatives come in a wide variety of forms, such as stock options and S&P futures. But the new institutional-grade Bitcoin derivatives take forms that are less common.

The first Bitcoin derivative for sophisticated parties to come to market was the TeraExchange (Tera) Bitcoin forward. The Tera contract works in the following way: First, on the initial trade date, the buyer and seller enter into a contract for a certain amount expressed in U.S. dollars. The minimum contract size is $1,000. Then, on the contract's settlement date, the buyer pays the seller in cash if the price of Bitcoin in U.S. dollars has increased since the trade date. The amount the buyer has to pay the seller is based on the size of the contract and how much the price of Bitcoin has appreciated since the trade date. On the other hand, if the value of Bitcoin decreases after the initial trade date, the seller makes the cash payment to the buyer.

The Tera Bitcoin forward is traded on a platform regulated by the Commodity Futures Trading Commission (CFTC) and known as a swap execution facility. The platform provides prices and matches up parties, but does not clear the trade or otherwise assume any risk related to the parties not paying each other. The Bitcoin swap is uncleared, meaning that the buyer and seller assume the risk that the trade will not properly settle. But as is typical with swap agreements, the Bitcoin forward requires collateral to be posted when the trade is entered, and for parties to make adjustments based on the market value of Bitcoin. Using collateral reduces counterparty risk.

The first Tera Bitcoin derivatives trade was executed on October 9, 2014, between digitalBTC and another party. digitalBTC is a publicly listed Australian a company that provides Bitcoin mining, trading, and liquidity-provision services. digitalBTC seems to have entered the forward to gain exposure to Bitcoin as opposed to hedging its Bitcoin price risk that arises from holding bitcoins due to its business activities.

A second type of Bitcoin derivative is under development by SolidX partners. According to its press release, the SolidX agreement will take the form of a total return swap, which is a relatively common type of derivative instrument that emerged in the late 1980s. A total return swap enables a buyer to get investment exposure to an underlying asset--including its gains and losses--without having to actually own the asset or necessarily even pay any money upfront.

A total return swap is structured the following way: the buyer pays the seller a set rate in exchange for receiving payments that reflect the gains, if any, from owning an underlying asset. If the underlying asset produces a gain from interest income or market appreciation, the total return swap buyer gets paid that amount. If the underlying asset suffers a loss, the the buyer must pay the swap seller the amount of the loss (in addition to the set rate).

The SolidX Bitcoin total return swap will give its buyer the same gains and losses it would have as if it purchased bitcoins outright (minus the fixed rate it pays to SolidX). Because bitcoins qualify as a type of "commodity" under the Commodity Exchange Act, the SolidX swap will be regulated by the CFTC.

The following diagram shows some basic structural differences between the Tera and the SolidX bitcoin swaps.

Both instruments permit parties to effectively invest in bitcoins without actually owning any. The benefit of doing so is that it allows merchants and financial institutions to gain exposure to Bitcoin without having to deal with anti-money laundering issues and other regulatory concerns that could arise from directly holding bitcoins.

There are some important differences between the Bitcoin forward and the swap, however. Only the Tera Bitcoin forward offers parties the ability to "short" the Bitcoin market and gain from a Bitcoin price decline. Merchants, investors, and others that hold bitcoins can benefit from Tera's forward giving them the ability to hedge their Bitcoin price exposure.

Another major difference is the source of counterparty risk. With a Tera Bitcoin forward, the other party to the trade will be the source of counterparty risk. With the SolidX Bitcoin swap, SolidX itself will be the source of the counterparty risk. The ability of SolidX to make good on its end of the bargain will depend on how well it translates Bitcoin price gains into an income stream for the buyer.

Gaining exposure to Bitoin may have different accounting and cash-management consequences with each instrument as well. The Tera Bitcoin forward only triggers the primary payment obligation on the settlement date. By contrast, the SolidX swap may require a more frequent exchange of cash flows. As a result, the SolidX product would have a more direct impact on earnings and liquidity. On the other hand, the buyer of the SolidX swap may not have to post collateral or any cash upfront, which may make the instrument more attractive than an equivalent Tera Bitcoin forward.

Ultimately, differences between the Tera Bitcoin forward and the SolidX Bitcoin swap will depend on the particularities of the terms of the trade and counterparties involved.

With the advent of these two products, and likely many more on the way, the Bitcoin economy will attract a wider range of commercial and financial market participants.